This year, the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, colloquially called the Nobel Prize in Economics, went to Robert E. Hall of Stanford University and Michael Woodford of Columbia University for their work in “microeconomic foundations of macroeconomic stabilization.” Those five words do not adequately describe their contributions. Hall and Woodford are macroeconomists whose major works emerged when macro was in crisis. Old school Keynesian economics had dominated economic policy discussions since the 1940s. Generally speaking, Keynesians advocated fiscal policy tools (specifically taxes and spending) to stabilize the economy. For about 20 years, those tools seemed to work. But starting in the late 1960s and through the 70s, the macroeconomic relationships broke down. A seemingly impossible confluence of rising inflation and high unemployment characterized this period. Keynesian spending policies were becoming impotent. Critics of Keynesianism rose, and macroeconomics called out for new theories.
It was during this period that macroeconomics began to explore more microfoundations. That is, rather than treating the economy as a series of aggregates and their relations to one another, economists started to explore how aggregate macroeconomic factors were the results of individual behavior, institutions, and expectations. Stabilization policy could not be simply levers pulled or pushed by the policymaker. Rather, stabilization policy had to include theories on how people will react to such changes, as well as their expectations about the future. Models such as rational expectations, adaptive expectations, and the permanent income hypothesis were developed during this period as a means to explain why these Keynesian stabilization policies failed.
One of the models that came out of this period was Milton Friedman’s Permanent Income Hypothesis. The basic idea is that people base their consumption decisions not just on current income levels, but on future income levels as well. If a person can spend or save freely, they will spread out their consumption so as to avoid major changes over their lifetime. Temporary windfalls will be saved, so that when those funds run out, the standard of living will not drop. Consequently, a temporary increase in income (say, from a temporary tax cut) would not increase spending in the economy: individuals will know the tax cut is temporary and save the funds so that when the tax returns to the previous level, their level of spending will not fall dramatically. People would only react to permanent changes in their income.
Robert Hall built on the Permanent Income Hypothesis. In his 1978 Journal of Political Economy paper “Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence,” Hall argued the Permanent Income Hypothesis is at least partially true: people do take the future into account when adjusting their consumption decisions. People will act according to expectations formed from available information. As information changes, so do their expectations and thus their consumption trends. However, since information changes are unpredictable and essentially random (if they weren’t, they wouldn’t be information changes and would already be taken into account by the consumer), changes in consumption are also unpredictable. Consumption changes, Hall argued, follow a random walk.
Hall’s argument has significant implications for macroeconomic stabilization policies. Under the Keynesian model, a given increase in income will mechanically generate a given increase in consumption, and thus national output. Readers with a background in economics will recognize this as the Keynesian multiplier. But what Hall showed, building off Friedman, is that such a mechanical relationship is conditional, at best. Whether the change in income was anticipated or unexpected, permanent or temporary, will influence how effective the policy will be. For example, if the government provides rebate checks every time there is a recession, the effectiveness of those rebates will fall over time. People will begin to anticipate them and adjust their behavior accordingly. Consequently, expected fiscal policy becomes impotent over time.
Hall’s random walk model does have its limitations, as he and co-author Frederic Mishkin noted in a 1982 paper in Econometrica entitled “The Sensitivity of Consumption to Transitory Income: Estimates from Panel Data on Households.” Not everyone can do such forward planning. Some households live paycheck-to-paycheck and do not have much flexibility to alter behavior. Consequently, they may face more limitations to consumption-smoothing and be more sensitive to changes in income. Thus, households can respond very differently to identical policies.
Michael Woodford’s work is a natural complement to Robert Hall’s. Whereas Hall focused on consumption and spending, Woodford focused on the central bank and the role of monetary policy. Woodford incorporates insights from three disparate but related microeconomic phenomena into a framework for understanding and evaluating monetary policy.
First, Woodford also built on the idea that households consume based not just on information about the present, but on expectations of the future as well. Those expectations are shaped by expectations of inflation, real interest rates, and future income. Like Hall, Woodford argued these expectations will influence how effective policy will be, but his focus was more on interest rate policy. If people anticipate changes in interest rates, they’ll take those changes into their planning.
Second, firms do not constantly change nominal prices; prices, at least in the short run, are sticky. Changing prices is costly and, to reduce costs, firms take into account expectations of future economic conditions when setting prices. Consequently, when aggregate demand shifts and nominal prices are sticky, firms will adjust output and employment rather than prices. This implies that monetary policy can have real effects in the short run, rather than simply producing inflation.
Third, the central bank influences activity not by changing the interest rate per se, but by changing its policy rate relative to the natural rate of interest. When the policy rate is below the natural rate, it will tend to stimulate demand. When the policy rate is above the natural rate, it will tend to reduce demand.
Taking these three insights together, Woodford developed a monetary theory that accounts for the expectations of firms and households. Specifically, his framework shows that the central bank affects macroeconomic behavior through both interest rate movements and setting expectations about future monetary policy. For example, say the Federal Reserve announces that it expects to keep interest rates low for an extended period. That changes people’s expectations of future monetary policy: there probably won’t be major increases in the future. In turn, that shapes their investing and saving behavior. Thus, even without changing rates, the Federal Reserve could influence current behavior. This communication has become known as “forward guidance.”
However, what matters here is that forward guidance is only effective to the extent people believe it. The central bank must have a credible commitment to its policies. If the central bank’s statements are not credible, forward guidance will not influence behavior, as it will not adjust expectations.
Both Hall’s and Woodford’s work falls under the macroeconomic school of thought called “New Keynesianism.” While the Nobel committee cited their work as research on “stabilization,” the academic debate continues about how effective these policies are. Regardless, both Hall and Woodford made significant theoretical advances in our understanding of how microfoundations can affect macroeconomic outcomes.
Read more of Jon Murphy’s writing at the Econlib Archive.
(1 COMMENTS)
